Management Shifts Can Signal Traders
Trading is, at its core, the assimilation of information into an opinion. The information could be a ratio calculated from a financial statement or a pattern noted on a chart. It could also be a news story. Or, in many cases, the information is a combination of several factors.
Traders watching the news recently were surprised by tech giant Alphabet (Nasdaq: GOOGL), parent company of Google. Executive Chairman Eric Schmidt abruptly resigned but announced he would be staying with the company as a technical adviser.
Schmidt came to Google from Novell Inc. when Google had just 200 employees. He helped the company become a dominant global force in search, online advertising and video. At the time he joined the firm, Schmidt was hired to famously provide adult supervision to the company.
In an interview at the time Schmidt was hired, one of the company’s foudners, Sergey Brin, was asked why he and co-founder Larry Page needed someone else to run Google. “Parental supervision, to be honest,” Brin replied.
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Schmidt proved to be a good hire. He presided over successes such as Google’s initial public offering in 2004; the launch of Gmail, Maps and the Chrome browser; the acquisition of YouTube in 2006; and the rise of Android into the world’s largest mobile operating system.
Now, the founders who were in their 20s when Schmidt came aboard seem to have developed the skills needed to manage the company. Other executives including Google Chief Executive Officer Sundar Pichai, Chief Financial Offer Ruth Porat and cloud head Diane Greene are also ready to lead the company.
When he joined as CEO in 2001, Google had fewer than 15 million unique monthly visitors online. A decade later, when he moved out of the CEO role, that number had grown to more than a billion.
What’s Next for Google?
Now, after this news, traders are asking what the future holds for the company. Here, of course, there are no solid answers.
The stock chart gives traders reason for caution. The stock has been trending higher but momentum recently slowed as can be seen in the chart below.
At the bottom of the chart is the stochastics indicator, a popular tool that measures momentum. Technical analysts look for momentum to confirm the price action. In this case, it has not been doing that.
While the price of GOOGL has been moving higher since November, the stochastics indicator has been making a series of lower highs. This is known as a bearish divergence and technical analysts expect a price decline to follow a set up like this.
Fundamentals also suggest that the share price of GOOGL could be headed lower. The stock is trading with a price to earnings (P/E) ratio of about 37 based on its trailing earnings. This is well above the computer services industry’s historic average of about 26.
It is likely now, given the change in leadership, that the stock price could stall.
Based on both the technical picture and the potentially overvalued fundamental perspective, it is possible the stock could dip over the next few weeks as traders evaluate whether or not there is more to Schmidt’s announcement than meets the eye.
The stock could now struggle while traders wait for news and they may have to wait weeks for meaningful news. The company is expected to announce earnings in late January. Prior to that, little, if any news is expected.
In the absence of news, there could be rumors about the company. Rumors are rarely a positive for a stock’s price but they can, and often do, fill the vacuum created by a lack of news.
With short term momentum pointing lower, traders should consider using strategies that benefit from lower prices for at least the next few weeks.
A Trading Strategy to Benefit From Potential Weakness
Because of the fact the stock is overvalued and in a down trend, traders should consider using an options trading strategies known as a bear put spread to benefit from the expected price move.
This Trading Strategies can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for Alphabet
The bearish outlook for Alphabet, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expires. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the December 29 $1,070 put can be bought for about $6.00 and the December 29 $1,067.50 put can be sold for about $5.00. This trade will cost about $1.00 to enter, or $100 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spend to open the trade, or $100. This loss would be experienced if GOOGL is above $1,070 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in GOOGL, the maximum gain is $1.50 ($1,070 – $1,067.50 = $2.50; $2.50 – $1.00 = $1.50). This represents $150 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 150% on the amount risked in the trade. This trade delivers the maximum gain if GOOGL closes below $1,067.50 on December 29 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $100 for this trade in GOOGL.